How to “De-FAANG” and Lower Your S&P 500 P/E Ratio

How to “De-FAANG” and Lower Your S&P 500 P/E Ratio

2017 was a year in which the market refused to be held down for long, making it through the entire year without posting a single negative month (on a total return basis). While this was very beneficial to investors in the broad index, this market rise was championed by a small number of very high performing names. The effect can be seen in both the concentration of contribution and the steadily rising P/E of the index at large. Therefore, it is worth examining what drove the market in 2017 (and the first two months of 2018) and how investors may be able to protect themselves against a pullback without trying to become market timers.

The S&P 500 (1/1/2017-2/28/2018)

Exhibit 1 above shows the annual average monthly P/E of the S&P 500 over the last 10 years and demonstrates how P/E’s have been steadily rising since the market crash of 2008/2009. A look closer at what is driving the S&P 500, reveals that the index’s 24.02% total return (1/1/2017–2/28/2018) has been concentrated among a small number of very high performing names. This concentration of returns manifests itself (see Exhibit 2 below) in the disparity between the S&P 500 Index and the S&P 500 Equal Weight Index over the specified time-period.

Exhibit 2

The divergence of the “cap weighted” S&P 500 from the “equal weight” S&P 500, is primarily a result of a small number of mega-cap stocks (weighted higher in the standard S&P 500), that have posted outsized returns. The clearest example of these winners is the FAANG group (including Microsoft, which has more recently made a case to join that designation).

Exhibit 3

The chart above shows that over this 14 month period, the FAANG +M names Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), Google (GOOG) (GOOGL) and Microsoft (MSFT) (just over 1% of index constituents) are up an average of 69.5%, which is almost 3x the S&P 500’s return over that same period. These spectacular returns – combined with how large the market caps of these companies have become – resulted in FAANG+M contributing almost 30% of the S&P 500 index return. While this has been hugely beneficial to investors who hold S&P 500-based investments or these names individually, it does raise questions about the sustainability of this narrowly lead leg higher.

In the last two weeks, with volatility inducing headlines on Apple and of course Facebook, investors have gotten a glimpse of what it means for the markets if FAANG+M sentiment shifts. The FAANG+M returns from 3/12/2018-3/23/2018 shown in Exhibit 4 below, demonstrate the live by the sword / die by the sword nature of when outperforming, overweight positions pull back.

Exhibit 4

It must be pointed out that this 12-day period is a very small sample size and the FAANG+M names could very well return to outperforming. However, it is important to keep in mind that market cap weighted indices allocate money to institutions simply because they are large and not necessarily because they have the best investment case going forward.In fact, the long run outperformance of smaller capitalization stocks vs their larger peers is a focal point of Eugene Fama and Kenneth French’s seminal research on the three-factor model.

Less Concentrated, Less Expensive, De-FAANG’d look at the S&P 500.

The Reverse Cap Weighted US Large Cap Index – Calculated by S&P Dow Jones, turns the traditional cap-weighted index on its head – weighting the constituents of the S&P 500 by (1/Market Cap), with the resulting index weighted in the reverse order of the S&P 500. Therefore FAANG+M (which as noted above has such a large weight in the S&P 500), has a drastically lower combined weight in Reverse (~13% in the S&P 500 (2/28/2108) vs. 0.09% in the Reverse Index (2/28/2018)). This redistribution of weight, implements a disciplined “Buy Low, Sell High” system which gives more weight to a segment of the S&P 500 (the smaller end of large-cap) that is underrepresented by traditional market cap weighted indices. While comprised of the same 500 stocks as the S&P 500, the Reverse Cap Index approach has the added benefit of offering a P/E ratio that is 10.4% cheaper – as seen in Exhibit 5 below.

Exhibit 5

*P/E ratio for trailing 12 months as calculated by Morningstar as of 2/28/2018

The Reverse Cap Index provides investors opportunity as a stand-alone strategy (should they feel we are in a market environment in which smaller cap will outperform), or as a tactical tool to combine with a traditional market cap weighted index in order to achieve any average weighted market cap, to fit their market outlook. More information on the Reverse Cap Index can be found here, including an in-depth white paper laying out the investment case for reverse cap indexing.

Conclusion

As the S&P 500 continues to become increasingly expensive as measured by P/E multiple expansion and given the recent volatility in the mega cap stocks that lead this market higher, investors may want to consider how they can get exposure to the S&P 500 companies in a way that defrays the concentration risk from the recent high flyers, while lowering P/E. As a tool, the Reverse Cap-Weighted US Large Cap Index provides flexibility of choice to allocate resources within this highly benchmarked universe.

Disclaimer:

The author, Josh Blechman, is the Director of Capital Markets at Exponential ETFs, an SEC Registered Investment Advisor. Exponential ETFs is the issuer of the Reverse Cap Weighted US Large Cap ETF (Ticker: RVRS).

The Reverse Cap Weighted U.S. Large Cap Index (Reverse) is a rules-based reverse capitalization weighted index comprised of the 500 leading U.S.-listed companies as measured by their free-float market capitalization contained within the S&P 500 universe. The Index has an inception date of October 23, 2017, with a back tested time-series inception date of September 28, 2007.

The Reverse Cap Weighted U.S. Large Cap Index (the “Index”) is the property of Exponential ETFs, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third-party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and the related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Exponential ETFs. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”).

Past performance of an index is not a guarantee of future results, which may vary. The value of investments may go down as well as up and potential investors may not get back the amount originally invested. Performance figures contained herein are contain both hypothetical and live returns; results, hypothetical or otherwise, are intended for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs, or expenses, which would reduce returns. Inclusion of a security within an index is not a recommendation by to buy, sell, or hold such security, nor is it considered to be investment advice. It is not possible to invest directly in an index.

The Index, strategy, and performance returns discussed are for informational purposes only and do not represent an offer to buy or sell a security and should not be construed as such.